Tuesday, December 16, 2008

Will Alt-A Resets Slam Alternatives?

Going further than analysts anticipated, the central bank said it had cut its target for the overnight federal funds rate to a range of zero to 0.25 percent, a record low, bringing the United States to the zero-rate policies that Japan used for six years in its own fight against deflation.

The move to a zero rate, which affects how much banks charge when they lend their reserves to each other, is to some degree symbolic. Though the Fed’s target had previously been 1 percent, demand for interbank lending has been so low that the actual Fed funds rate has hovering just above zero for the past month.

Far more important than the rate itself, the Fed bluntly declared that it was ready to move to a new phase of monetary policy in which it prints vast amounts of money for a wide array of lending programs aimed at financial institutions, businesses and consumers.

In essence, the Fed is embarking on a radically different route to stimulate the faltering economy, and it puts the Fed chairman, Ben S. Bernanke, in partnership with the incoming Obama administration as it moves on a parallel track.

The Dow Jones industrial average climbed 359.61 points, or 4.2 percent, to close at 8,924.14. The Standard & Poor's 500-stock index jumped 44.61 points, or 5.1 percent, to end at 913.18, while the Nasdaq composite index gained 81.55, or 5.4 percent, to finish at 1,589.89.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed's Open Market Committee said in a statement that will be closely parsed by investors. "In particular, the committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Stock prices climbed across the board, led by financial and transportation companies, as investors cheered the Fed's latest attempt to loosen credit and stanch one of the worst economic downturns since the Great Depression.

...

Treasurys also soared after the Fed said it plans to look into purchasing large amounts of long-term Treasurys, perhaps as a way of boosting the housing market. Though prices are already at historic highs, they will have more room to grow if the government begins to buy up its own long-term debt.

"Most buyers right now believe that old adage, 'You can't fight the Fed,'" said Kenneth Naehu, managing director of Bel Air Investment Advisors. "Clearly, otherwise, the 10-year and 30-year bonds are not attractive at these low levels."

By purchasing 10-year Treasurys in large volume, the Fed could potentially help to lower mortgage rates for prospective home buyers. Thirty-year fixed rate mortgages, which have historically moved in step with the 10-year note, currently hover around 5.5% despite 10-year Treasury yields of less than 2.5%. Before the credit crunch, the rates were more typically within a range of 1.5 to 2 percentage points from one another.

The message is clear, rates are going to stay at historic lows for a very, very long time. Also, the Fed will accelerate its quantitative easing policy, buying up long-term bonds and if need be, corporate bonds and stocks. Anything to avoid deflation.

Why was the Federal Reserve so aggressive in cutting rates today? My hunch is that Fed Chairman Bernanke played a clip from Sunday's 60 Minutes, A Second Mortgage Disaster?, and reminded his colleagues on the Federal Open Market Committee that the second wave of mortgage resets will hit the "Alt-A" and "option ARM" mortgages (see figure above).

You can watch the entire clip by clicking here, but let me quote the following:

One of the best guides to the danger ahead is Whitney Tilson. He's an investment fund manager who has made such a name for himself recently that investors, who manage about $10 billion, gathered to hear him last week. Tilson saw, a year ago, that sub-prime mortgages were just the start.

"We had the greatest asset bubble in history and now that bubble is bursting. The single biggest piece of the bubble is the U.S. mortgage market and we're probably about halfway through the unwinding and bursting of the bubble," Tilson explains. "It may seem like all the carnage out there, we must be almost finished. But there's still a lot of pain to come in terms of write-downs and losses that have yet to be recognized."

In 2007, Tilson teamed up with Amherst Securities, an investment firm that specializes in mortgages. Amherst had done some financial detective work, analyzing the millions of mortgages that were bundled into those mortgage-backed securities that Wall Street was peddling. It found that the sub-primes, loans to the least credit-worthy borrowers, were defaulting. But Amherst also ran the numbers on what were supposed to be higher quality mortgages.

"It was data we'd never seen before and that's what made us realize, 'Holy cow, things are gonna be much worse than anyone anticipates,'" Tilson says.

The trouble now is that the insanity didn't end with sub-primes. There were two other kinds of exotic mortgages that became popular, called "Alt-A" and "option ARM." The option ARMs, in particular, lured borrowers in with low initial interest rates - so-called teaser rates - sometimes as low as one percent. But after two, three or five years those rates "reset." They went up. And so did the monthly payment. A mortgage of $800 dollars a month could easily jump to $1,500.

Now the Alt-A and option ARM loans made back in the heyday are starting to reset, causing the mortgage payments to go up and homeowners to default.

"The defaults right now are incredibly high. At unprecedented levels. And there’s no evidence that the default rate is tapering off. Those defaults almost inevitably are leading to foreclosures, and homes being auctioned, and home prices continuing to fall," Tilson explains.

"What you seem to be saying is that there is a very predictable time bomb effect here?" Pelley asks.

"Exactly. I mean, you can look back at what was written in '05 and '07. You can look at the reset dates. You can look at the current default rates, and it's really very clear and predictable what's gonna happen here," Tilson says.

Just look at a projection from the investment bank of Credit Suisse: there are the billions of dollars in sub-prime mortgages that reset last year and this year. But what hasn't hit yet are Alt-A and option ARM resets, when homeowners will pay higher interest rates in the next three years. We're at the beginning of a second wave.

"How big is the potential damage from the Alt As compared to what we just saw in the sub-primes?" Pelley asks.

"Well, the sub-prime is, was approaching $1 trillion, the Alt-A is about $1 trillion. And then you have option ARMs on top of that. That's probably another $500 billion to $600 billion on top of that," Tilson says.

Asked how many of these option ARMs he imagines are going to fail, Tilson says, "Well north of 50 percent. My gut would be 70 percent of these option ARMs will default."

"How do you know that?" Pelley asks.

"Well we know it based on current default rates. And this is before the reset. So people are defaulting even on the little three percent teaser interest-only rates they're being asked to pay today," Tilson says.

...

And there are tough years to come because, just like the sub-primes, the Alt-A and option ARM mortgages were bundled into Wall Street securities and sold to investors.

Sean Egan, who runs a credit rating firm that analyzes corporate debt, says he expects 2009 to be miserable and 2010 also miserable and even worse.

Fortune Magazine cited Egan as one of six Wall Street pros who predicted the fall of the financial giants.

"This next wave of defaults, which everyone agrees is inevitably going to happen, how central is that to what happens to the rest of the economy?" Pelley asks.

"It's core. It's core, because housing is such an important part. We're not going to get the housing industry back on track until we clear out this garbage that's in there," Egan explains.

"That hasn't cleared out yet. We haven't seen the bottom," Pelley remarks.

"It's getting worse," Egan says. "There are some statistics from the National Association of Realtors, and they track the supply of housing units on the market. And that's grown from 2.2 million units about three years ago, up to 4.5 million units earlier this year. So you have the massive supply out there of units that need to be sold."

"What with the housing supply increasing that much, what does it mean?" Pelley asks.

"It means that this problem, the economic difficulties, are not going to be resolved in a short period of time. It's not gonna take six months, it's not gonna 12 months, we're looking at probably about three, four, five years, before this overhang, this supply overhang is worked through," Egan says.

In the next four years, eight million American families are expected to lose their homes. But even after the residential meltdown, Whitney Tilson says blows to the financial system will keep coming.

"The same craziness that occurred in the mortgage market occurred in the commercial real estate markets. And that's taking a little longer to show. But there are gonna be big losses there. Credit cars, auto loans. You name it. So, we're still, you know, we're maybe halfway through the mortgage bubble. But we may only be in the third inning of the overall bursting of this asset bubble," Tilson says.

"Does that mean that the stock market is gonna continue plunging as we've seen the last several months?" Pelley asks.

"Actually we're the most bullish we've been in 10 years of managing money. And the reason is because the stock market, for the first time I can say this, in years, has finally figured out how bad things are going to be. And the stock market is forward looking. And with U.S. stocks down nearly 50 percent from their highs, we're actually finding bargains galore. We think corporate America's on sale," Tilson says.

The stock market will still have a lot of figuring to do with more troubling news on the horizon. The mortgage bankers association says one out of 10 Americans is now behind on their mortgage. That's the most since they started keeping records in 1979.

Now, let me ask you, if you are the Fed, what do you think you are going to do knowing this second wave of mortgages is about to reset and the risks of massive defaults loom over a weak economy?

You are going to lower rates to zero and PRAY that you contain the defaults as much as possible. But even these historic low interest rates will not prevent Alt-A loans from spiraling downward:

It seems there is always something that makes it relevant again. Yesterday, it was a report from Fitch Ratings that says it expects losses on Alt-A loans to far exceed its earlier downgraded assessment.

As you look at the Fitch commentary, keep in mind that they include both Alt-A loans and Option ARMs in their Alt-A classification.

The rating agency said it now expects average cumulative losses on 2005, 2006 and 2007 vintage Alt-A transactions to hit 2.72, 6.78 and 9.58 percent, respectively, up dramatically from expectations at the agency earlier this year.

Fitch cited a “rapid increase in 60+ day delinquencies experienced over the past six months,” despite servicers’ collective efforts to hold off on actual foreclosure sales — likely implying that a halt to foreclosures is having little effect in resolving borrower delinquencies.

Between May and October 2008, Fitch said that 60+ day delinquencies for the 2007 vintage increased from 8.80 percent to 14.65 percent; 2006 and 2005 vintages also experienced steep increases rising from 10.30 percent to 14.24 percent and 6.57 percent to 8.79 percent, respectively.

Now look at the chart and what do you see? Obviously, we aren’t even into the teeth of the resets and recasts for these loans. In fact, the lion’s share of the adjustments isn’t even scheduled to take place until somewhere in 2009 continuing into 2010. So why are they apparently falling apart right now?

You can speculate until the cows come home about why this is falling apart so fast but here are a couple of ideas. I’m sure there are others.

A lot of these loans were used to purchase somewhat upscale to frankly upscale homes by people that had no business buying in that price range. The purchases were facilitated by stated income loans and the only way they could possibly work was for home prices to continue to escalate.

When the bubble popped the game was over but the buyers had a bit more in reserve than the subprime borrowers so it just took a little bit longer to work its way through. The reserves are gone and it’s just a matter of time until the foreclosures roll through.

The second thought that occurs to me is that the recession is beginning to bite. The first wave we now see may well be borrowers who were dependent on bubble economics. Real estate agents, mortgage brokers, title companies, bankers, you name it. They started getting hammered by the recession earlier than most and logically are the first to default. They also tended to buy above their means as they believed in the fairy tale. If this is true, then we’re just seeing the tip of the problem.

This may well signal the beginning of a move up the scale in terms of foreclosures. We aren’t to a large degree talking about first time homebuyer types of homes now. The upper end is starting to get hit and that has a whole new host of implications. These homes are not particularly attractive to investors as the price generally is too high for the property to pencil out as a viable rental.

Additionally, the dispossessed homeowners are not likely to adapt well to a much lower standard of living. Moving from granite counter tops in a 4000 square foot house to Corian in a tract home is not an easy adjustment.

I expect that this development is going to provide more juice for the loan modification crowd. These borrowers have more political clout and most communities don’t want to see a lot of vacant houses in their signature neighborhoods. The issue, however, is going to be one of scale.

To modify these loans in order to keep the occupants in the house is going to require some breathtaking write-downs of principal. Forget lowering interest rates, we are talking about debt forgiveness that will likely be in the hundreds of thousands of dollars per property. That, my friends, is one big political and economic problem.

Every now and then, I think that we may be working our way out of this mortgage morass.

Then something like this pops up. I suspect that I may well pull this old chart out a couple more times before I get to quit writing about this.

Keep the above stories in mind the next time the president of your pension fund tells you "nobody could have predicted this crisis" or my favorite, "things will get better in 2009 and we invest for the long-term".[code for we screwed up and hope things will improve before we get fired!]

In fact, most have taken only small and conservative steps to manage their risk at a time when careful monitoring and measurement and strong, meaningful actions should be the order of the day.

However, Hewitt's survey also found there are steps employers can take now that will enable them to ensure the long-term health and stability of their pension plans, as well as protect them from volatile market and economic conditions.

Since the start of the credit crunch in the last quarter of 2007, pension plan assets on a global level have plummeted by $4 trillion--three times greater than the amount of money provided in government bail-outs to global financial institutions. Against this background, Hewitt conducted a survey of 171 plan sponsors in 12 countries to determine their attitudes and actions around managing pension risk.

In the U.S., Hewitt's survey revealed that many companies have been relatively early movers in making plan design changes to their defined benefit programs. However, they have yet to employ the full range of actions at their disposal to manage pension risk, such as more sophisticated investment solutions, integrated funding and investment strategies and liability management techniques.

"While some U.S. companies did take early action to manage pension risk leading up to the current economic situation, a majority of plan sponsors remain exposed to events like those we are experiencing." said Joe McDonald, head of Hewitt's Global Risk Services practice in North America. "Recent market performance has put plan sponsors back in the position of trying to manage their under-funded pension plans--a position they struggled with for the better part of this decade. Now is the time for plan sponsors to review their risk management strategies to ensure they make sense in today's markets, given current funded levels and the ever-changing regulatory framework in which we operate."

Hewitt's survey identified a significant, determined and growing minority of U.S. companies that have adopted leading-edged practices that have better positioned themselves to weather volatile economic environments and market conditions.

These players can be characterized by their attitudes to all aspects of understanding and addressing their pension risks, including: Embedding risk within an overall risk framework. Appropriately managing the trade-off between risk and reward starts with proper risk identification.

Not surprisingly, the majority of respondents worldwide identified financial risk as the most important (73 percent). In the U.S., financial risk and regulatory risk ranked highest in importance--most likely due to recent pension legislation, including the Pension Protection Act (PPA) of 2006.

More alarming is that governance (12 percent) and strategic risk (4 percent) received such low marks. Additionally, successful companies view and manage pension risk within the broader framework of the company's overall risk profile and strategy. Currently, less than one-quarter (24 percent) of companies view risk in this way.

Measuring risk against clear and consistent metrics. Leading plan sponsors realize that in order to adequately determine risk exposure and set long-term risk objectives, it is critical to implement clearly defined and consistent metrics that evaluate the interaction of pension assets and liabilities, rather than just evaluating one side of the risk equation.

Only 18 percent of U.S. plan sponsors report benchmarking plan asset performance relative to a liability-based benchmark, while asset-only benchmarks such as market indices (80 percent), peer group comparisons (60 percent) and expected return hurdle rates (54 percent) all received higher marks. Using a liability-driven benchmark allows sponsors to look at the impact on the plan's funded status rather than assets in isolation, enabling them to make better decisions in seeking risk-adjusted returns for their plans.

"How plan sponsors define and measure performance will ultimately translate into how they make decisions. As a result, performance metrics need to be clear and consistent with the plan sponsor's objectives. This typically leads to liability-based metrics for both risk and return," noted McDonald.

Balance short-term volatility with long-term goals. When asked about factors that influence their attitude toward pension risk, a majority of U.S. companies (82 percent) cited income statement and cash volatility as the primary driver, while only 16 percent are focusing on the long-term rewards of risk-taking as the primary influence on their attitude toward risk. This increasing focus on short-term results creates new problems that are best solved with new solutions such as derivative-based investments and liability settlement options (e.g., lump-sum payments).

"Many companies see risk as being a short-term issue and often a short-term accounting problem," said Paul Garner, principal in Hewitt's International Benefits Consulting practice. "The relative scarcity of capital in the current credit crisis, combined with down markets and the requirements of the PPA, will undoubtedly increase the prominence of cash contributions. Successful plan sponsors will be those that achieve balance between short-term fluctuations and long-term goals."

Taking action to respond to risk. In the turbulence of the current financial markets, companies must take decisive actions to manage risk. While U.S. companies have been relatively early movers in making plan design changes--66 percent have closed their defined benefit plans to new entrants and 24 percent have already stopped accruals--many plan sponsors find that benefit changes do little to the risk profile of their pension plans while having a significant impact on employees.

Successful plan sponsors are focused on their pension investment and funding strategies. In the U.S., half are considering reducing the asset-liability mismatch in their plans, while 60 percent intend to establish or revise their funding policy.

In addition, successful plan sponsors are transitioning management activities to those with the resources and expertise to excel. Many are either considering or have already outsourced much of retirement plan management, such as asset manager monitoring (54 percent), asset manager selection (40 percent), Liability Driven Investing (LDI) (20 percent) or other liability matching techniques (38 percent), and tactical asset allocation changes (32 percent). This trend will likely continue as the task of managing retirement programs becomes increasingly complex.

Continuous monitoring. Companies best aligned to manage the continued economic turmoil routinely reassess risk in order to make appropriate decisions based on the best information possible. While 82 percent of U.S. companies in Hewitt's survey reviewed asset return levels quarterly or more frequently, only 14 percent measured funded status more than quarterly--illustrating the clear disconnect between the asset and liability sides of the risk equation.

When it comes to risk measures, the picture is even bleaker, with only 72 percent of companies reviewing risk metrics on an annual or less frequent basis. This level of infrequency makes it more difficult for companies to capitalize on opportunities that present themselves from both a risk and return perspective.

"Clearly these are challenging times for plan sponsors, and all stakeholders," said McDonald. "The good news is that there are steps that can be taken now to manage pension risk so that companies are better positioned to navigate today's choppy waters and to weather future storms. Hopefully, recent events have made plan sponsors stand up, take notice and seriously consider implementing these emerging best practices."

These are challenging times, but instead of burying their heads in the sand, pension funds should start rethinking their game plan and start adopting a holistic approach to risk - one that carefully considers how risks from all asset classes influence each other.

United States college endowments and state pension funds ploughed billions of dollars into hedge funds and private-equity investments as a way to balance their stock holdings, and for a time they got supercharged returns.

Those days are over. From Harvard University to the state pension fund of California, officials are watching the value of their alternative investments shrink.

So far, the losses are mostly on paper, but analysts say they could eventually lead to reduced payouts to retirees, higher taxes so state governments can fulfil their promises, or less cash available for colleges to give out in financial aid.

"Everyone was in a desperate search to find returns," says Colin Blaydon, head of the Centre for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business. "Now they have to face the dirty little secret that those investments aren't in great shape."

In recent years, endowments and pensions heaped cash into hedge funds - private investment funds that often use unconventional and risky trading strategies. And they also bought into private equity funds, which make direct investments into private companies or buy them out.

It's too soon to know the depth of the damage from these investments. Annual results won't be in until January for pensions and July for endowments.

But there are already indications that the value of these alternative investments is falling, including disclosures from some publicly traded private-equity firms that some of their holdings are worth less than they were just months ago. The weakness in those holdings has delivered another punch to colleges and pension funds, which are bracing for the worst.

Harvard University announced last week that its endowment tumbled since July 1 by about US$8 billion ($14.7 billion), or 22 per cent, to about US$29 billion, and said that "sobering figure" doesn't fully capture its losses because it doesn't reflect declines in its private-equity and real estate investments. It forecast total losses for its fiscal year ending in June 2009 could be as much as 30 per cent, its worst performance on record.

"All of us will need not merely to contemplate changes at the margins, but to take a more fundamental look at how to align our spending with revenues that will be significantly reduced from what we had imagined just a few months ago," said university leaders in a letter to deans dated December 2.

In California, the public pension fund Calpers says state, local and county governments may have to chip in as much as an additional 4 per cent beginning in mid-2010 to cover its pension losses.

Its total assets had fallen from US$260 billion last fiscal year to just US$178 billion at the beginning of this month. The pension fund for public employees in Wisconsin says it may have to cut monthly payments to retirees by as much as 3.5 per cent - the first reduction in its 26-year history. Its Core Fund, a mix of investments including private equity, lost 26 per cent from January through October.

If that happens, Berland Meyer, a retired deputy school superintendent in Wausau, Wisconsin, said he and his wife, a retired teacher, expect they could receive up to US$1000 less a month.

"We won't go out to eat as much as we have in the past," he said. "I'm sure I won't be buying as many trinkets at Home Depot. We'll do a lot more thinking before we spend."

This was hardly what pension funds and endowments had in mind. After the dot-com stock bust wrecked their portfolios at the start of the decade, pensions and endowments poured cash into hedge funds, private equity, commodities and real estate - and for a few years, it looked like a smart move.

For private-equity firms, the strategy was to buy companies, strip out costs and flip them for a profit. Investor cash and massive debt fuelled their buying sprees.

The Robert Wood Johnson Foundation, which has more than U$10 billion in assets intended to support healthcare causes, boosted its alternative holdings from 13 per cent of its total investments in 2001 to 33 per cent in 2007, according to its financial reports. It has not disclosed any recent information about performance.

And last year, the nation's state and local pension funds put US$147 billion into alternative investments, 18 per cent more than the year before, according to research by the National Association of State Retirement Administrators.

Educational endowments put about US$144 billion into alternative investments from July 2006 through June 2007, about 8 per cent more than the year before, according to Commonfund, which advises and manages money for universities and nonprofits.

Critics say the party had to end.

Doug Kass, president of the Florida investment firm Seabreeze Partners Management, says hedge and private-equity funds overpaid for many takeovers, used too much debt to finance the deals and charged excessive fees. So when bad times come and the now-private companies struggle, those investors will be the first to lose if companies go bankrupt or need restructuring.

"These funds relied on the kindness of institutional investors who were intoxicated by hysterical returns," says Kass, who is known as a short-seller, making bets on declines in the market.

Already, managers of hedge and private-equity funds are pressing investors to pony up more cash to avoid having to sell assets at fire-sale prices.

At the same time, some pension funds and endowments are looking to sell their alternative holdings - and get out before they're hurt even more.

Private-equity funds account for about US$900 million of the University of Virginia's endowment and other funds, about one-fifth of the total holdings. Those private-equity investments dropped nearly 13 per cent from July to September. The company that manages the holdings may sell some of the private-equity investments "at attractive prices", according to a recent letter from its CEO.

But anyone selling now faces a weak market.

"Hedge funds are supposed to act as insurance against market volatility," says New Jersey state Senator Joseph Pennacchio. "Now we have to insure the insurance."

Insure the insurance? I guess that means getting back to basics, buying stocks based on Benjamin Graham's value method and making sure your asset allocation contains good old government bonds - the only asset class that protects your portfolio from the ravages of deflation.

He doesn't have a blackberry. He barely uses e-mail but when it comes to money matters, Stephen Jarislowsky is on top of things. He is one of Canada's wealthiest people and leading philanthropists. He runs an investment counseling firm that manages more than 50-Billion-dollars worth of funds.

Listen carefully to why he thinks fear will supersede greed in the coming years and why people will have little choice but to pay down debts. He thinks that we need a period of "controlled inflation" to wipe off the debt overhang, but he acknowledges that the risk of deflation is there if policymakers fail to properly address the economic crisis.

My favorite part of the interview is when discusses his views on how money is not important in his life and how he is concerned with how today's generation is disconnected with previous generations and from our past.

You are wise man, Mr. Jarislowsky, and I hope some of the people from my generation listen to you and heed your sage advice.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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